We played on seesaws as kids. How can we make our money do more work with less effort?
We might not remember the lesson about levers and simple machines from school, but the seesaw below might be familiar. Levers allow us to move things with less work.
Our favorite philosopher was caught saying:
Give me a lever long enough and a fulcrum on which to place it, and I will move the world. - Archimedes
He knew that, with enough leverage, a little effort could make big things happen. The same principle applies to investing. By using margin, we can apply leverage to magnify returns with less money.
What is margin?
In a cash account, we need the full cash amount to buy or sell an investment. On the other hand, a margin account allows us to make trades with some of our cash or investments and borrow the rest using the investments and cash in the account as collateral.Some types of trading, such as using stock options or short-selling, can only be done in margin accounts.
The concept is similar to getting a mortgage to buy a house. The bank keeps the house as collateral until we pay off the loan. Collateral in our margin account assures our broker that we can pay back what we borrowed.
Borrowing money like this is known as leveraging your position. A leveraged position amplifies the potential gains and losses of an investment.
Calling for reinforcements
As with any loan, the margin balance will accrue interest. The difference is that there is no repayment schedule as long as we hold enough collateral in the account.
Brokerages may require us to keep somewhere between 25% - 40% of the total account value as collateral, either cash or the value of your investments. If the value of our collateral falls below that, we’re faced with a margin call.
A margin callmeans that we need to add more collateral to our account. We can add cash, add other investments, or close some positions to lower the margin balance. If we don’t meet the margin call, our broker has the right to close out any open positions, such as forcing a sale of stock, without our approval.
Investing with margin can be a powerful tool to increase your returns, but it’s much riskier.
Consider your risk tolerance and your financial circumstances since you’ll have to pay interest on the margin loan. You'll also be required to deposit more money or investments if you're faced with a margin call.
You can limit these risks by using protective stop orders that limit losses from any stock positions and keeping enough collateral in the account.